In the energy-lending landscape, debt deals are growing in number and size. For some companies, it’s a straightforward matter of market timing: the current interest-rate environment is making the cost of debt financing appealingly low—an attractive component to any capital structure.

As such, many companies are examining their current debt deals and opting to renew, upsize or modify existing credit facilities. New debt demand is being driven, in part, by drilling in the shale plays and a small amount of acquisition activity.

“In terms of availability there is an increasing appetite and supply of energy credit available,” says Mark Fuqua, senior vice president and manager, energy lending, Comerica Bank. “In general, banks have become more aggressive and willing to hold larger amounts in credits. Many banks are trying to grow and they like the economics in energy. The capital markets—especially the bond markets—have been so strong that, while we’ve seen some growth in relationships and commitments, there’s not much growth in our outstanding loans.”

Prices have come down substantially for natural gas and banks have adjusted their price decks, which will probably result in some contraction in bank availability for debt, he says. But, compared with one year ago, the appetite for debt deals is substantially better.

“Companies are starting to have more leverage in these relationships and we’re seeing the spreads contract a little. The tenors on the loans are also expanding. For a while, there was hardly anything beyond a three-year deal, but now we’re seeing more that stretch out to four or five years. The credit spigots are definitely opening.”

The picture for debt financing has also brightened as the markets have generally benefited from a significant amount of monetary stimulus. Liquidity is strong and reflected in current Treasury rates and the interbank cost of funds, a good proxy of which is the London Interbank Offered Rate (Libor), says Dennis Petito, managing director and head, North American energy, Credit Agricole Corporate and Investment Bank (CA-CIB). Specifically, the 10-year Treasury is at 2.74% and the three-month Libor is 0.292%.

“Even if credit spreads have risen from the antediluvian levels—pre-Lehman Brothers bankruptcy—clients can still raise debt all-in coupons that are well below the cost of equity. For example, average high-yield energy spreads came in under 580 basis points (during the week of September 12), enabling a ‘B’-rated company to issue 10-year money at less than 8.5%. One split-rated (B1/BB) company issued 10 ½-year notes at a yield of 7.125% during the same time period.

“Historically, these are very low coupons and reflect the enormous amount of capital flowing into the funds,” adds Petito. “The bond markets, except for the high-grade sector, were very tentative until recent quarters. CA-CIB has remained an active player in the first- and second-lien market throughout the crisis, but now several banks that were on the sidelines are coming back in force. Even sub-investment-grade companies are able to line up bank funding now at rates that are extraordinarily low—in some cases well below 2%.”

With such low rates, if a company needs to term out existing debt, and it can refinance it on an economic basis, now may be a great time to do it.

“This decision is a no-brainer for company management and boards,” says Vean Gregg, managing director and group head, Americas oil and gas investment banking, JP Morgan. “Debt that can be refinanced at historically attractive rates and locked in for 10 years isn’t a decision with much risk of regret. As a result, especially in upstream, we’ve seen several midcap companies—sub $10 billion in enterprise value—issue debt at or below 7% yields.”

Proceeds from the debt capital markets and banks have been used in a variety of ways. Much of the debt issuances has replenished liquidity under bank revolving credits. Funds have also been used to finance capex budgets that had been reduced, Petito says.

Historically, in 2007-2008, about half of the oil and gas high-yield and investment-grade volume was driven by M&A and acquisitions, but there were also refinancings, maturities and term-outs that had to be done, Gregg says.

“In 2009, post the financial collapse, our numbers show there was about $20 billion of debt issuance in the oil and gas high-yield space, and 95% of this was for refinancing while only 5% was for M&A. About 50% of the debt issuance was in oilfield services, midstream and refining while the other 50% was in the upstream.

“In 2010, there has been approximately $31 billion of issuance in the oil and gas space thus far, and about 80% has been for refinancings, while 20% has been M&A driven. The M&A percentage is growing, but it’s not quite where it was in 2007-2008 because many companies have maturities and/or opportunities to refinance callable bonds at lower levels now than where they were at original issue five or 10 years ago.”

Debt Expansion

In recent quarters, individual debt announcements from larger independents have climbed into the billions, largely supporting the perception that liquidity in the markets has grown and funds want to put capital to work.

In 2009 there were only a few deals larger than $1 billion in the oil and gas high-yield space. By contrast, in 2010 to date there have been at least 10 deals that were greater than $1 billion, Gregg says.

“Last year the overall high-yield market issuance was about $175 billion in volume, a record year. Issuance in 2010 has already blown past that volume, and we’re on track to potentially surpass $200 billion by year-end. The investment-grade market is modestly softer in overall year-over-year volume following a very robust 2009.

“Last year even high-grade companies were driven by the need to shore up liquidity. So bonds were frequently issued to pay down outstandings on a credit facility; this was the soup du jour in 2009 for all companies at all rating levels. In 2010 we entered the year as well capitalized as oil and gas companies have ever been, partially because companies have taken advantage of the low coupons in the debt markets, and they have reprioritized the value of liquidity.”

As recovery rates have generally been favorable—compared to other industrial sectors—creditors have viewed energy as a safe bet, Petito says. However, the size of some of the facilities is still surprising, given current gas prices.

“On the other hand, there’s definitely a lot of capital available from both private and public markets, and people see opportunity in that,” Fuqua says. “As a result, energy companies are growing. It’s been fascinating to see the rig count moving from 20% oil rigs to more than 40%. Good oil prices and improved production in liquids-rich plays are creating a lot of value for companies, and that also allows these debt structures to get bigger.”

Fuqua says some of his firm’s more interesting debt deals of late have been in the services sector, one of which is with a privately held, South Texas company that does coiled tubing and fracing in the shales.

“The demand for their services has really grown through a combination of better market conditions and the company being able to secure contracts that are longer than month-to-month. It’s allowed them to be more aggressive in purchasing equipment, and have enough cash flow to allow us to be more aggressive in financing a lot of that growth with debt capital.

“We’ve done two upsizings with this company, and the most recent one is in excess of $100 million with fees and rates that are more normalized that what they would have been a few quarters ago.”

In general, Comerica’s mix for debt deals has been 60% E&P, 20% midstream and 20% service companies.

Meanwhile, Credit Agricole CIB has been actively building its global energy franchise. After anticipating early last year that the debt capital markets were going to open up, the firm accelerated the build-out of its capital-market product capabilities and has strong product execution in both high-yield and high-grade bonds in the U.S. and Europe. In year-to-date 2010, CA-CIB has been a player in 45% of energy-related, high-yield transactions.

“One deal we are most pleased with is our leadership role in the McDermott restructuring that resulted in the spinoff of Babcock and Wilcox Co.,” says Petito. “This was particularly interesting for me because it brought back many memories. McDermott acquired Babcock and Wilcox in the late 1970s when I started my banking career. Thirty years later, Page Dillehunt, one of the senior bankers on my team who heads our global oil and gas services franchise, was the lead banker in the $900-million financing of the McDermott revolving credit; we were also a managing lead arranger on the Babcock facility.

“David Gurghigian, another senior banker on my team, led the financing for Willbros’ acquisition of Infrastrux last quarter, where CA-CIB was the primary underwriter of the bank and term-loan B facilities.

“Most recently, CA-CIB was a joint book-runner in Linn Energy LLC’s high-yield issue and we are a top-tier player in their credit facility. Tom Byargeon heads our independent producers group and manages this relationship. CA-CIB was the No. 1-rated project finance bank in the world in 2009, and we are lead arranger on many global deals.”

In late 2009, JP Morgan advised an E&P that merged with a similarly sized E&P, and it required more than $3 billion of underwritten committed financing. At the time, an underwritten bridge for a sub-investment-grade company had not been done in the oil and gas space since the financial meltdown. This deal generated one of the billion-dollar-plus bond deals that were done in early 2010, and it tested the limits of the bank market.

“The key part of this story was establishing confidence that, at closing or soon after, the company would be positioned to get the desired permanent capital structure in place and begin achieving the benefits of the merger,” says Gregg.

“At the time, bankers generally pegged the total bank market capacity for sub-investment grade, reserve-based loans as being around $2 billion. Since this deal, we’ve seen more confidence around M&A and the ability to raise larger amounts of capital from banks.”

Proceed with Caution

Though the low coupons on the debt that has been issued lately are attractive, companies would do well to approach the debt markets with caution. The low yields are somewhat of a barometer of the still-delicate nature of the global economy, and Petito says companies that have a high degree of operating leverage and high marginal costs of production need to operate with a comparatively lower degree of financial leverage.

“This is ‘Finance 101’ but you’d be surprised how many forget it. Gas prices remain weak and will likely remain that way for some time as the supply side is adapting slowly to the overhang in deliverability, and it will take time for the demand response to register its impact on the spot and forward markets. Unless a company can make a stable and reasonable return on capital in today’s price environment, it should remain very cautious in the use of debt.”

Fuqua adds that talking with a variety of banks is a good place for companies to start in researching their debt options. Smaller companies may benefit from hiring an advisor to review their existing capital structure and the company itself to help management teams access the right sources of capital.

“Whether or not debt is right for a company is always a function of risk and return. The smaller players won’t have as much access as the medium to large players, especially if they’re not located in one of the major energy markets. From the banks’ perspective, there’s also going to be some bias against riskier areas like offshore. You have some institutions that are willing to go further out on the risk spectrum, but this is a rarity these days.”

Bonds are typically used as a longer term, more permanent form of capital. If a company has a permanent level of debt it needs to carry relative to company and capitalization, the bond market is a good place to raise capital, Gregg says.

“Bank lines are often used to fund short-term acquisitions and liquidity needs. The choice between debt and equity has a lot to do with the nature and development status of the underlying assets, especially in relation to a company’s ability to service the debt while meeting ongoing capital needs and fixed obligations.”

For several quarters, more energy companies turned to the public markets for debt deals. While more expensive, the terms are longer and it’s relatively cheap money compared with previously. Until recently there were concerns about filling out large bank groups for debt transactions, Fuqua says.

“There weren’t enough participants at a big enough dollar amount to do really big deals. We’ve seen companies willing to pay a premium to refinance their bank debt with bonds, but this may change as the bank markets get more robust. So, we may see companies shifting back to doing what they can with the banks.

“Management teams know the oil and gas business is volatile, and they want to have a good blend in their capital structure between low-cost, short-maturity bank debt and higher-cost, lower-maturity bonds.”

Right Timing

While some companies are being drawn to the debt markets purely because of great interest rates, others are tapping this financing option for an additional reason: their production-growth cycle says, “It’s time.”

Denver-based Kodiak Oil & Gas Corp. exemplifies this scenario. The independent is currently focused on oil in the North Dakota Bakken play, where it started development in late 2008. From the time the company was founded in 2001 until May 2010, it had no debt.

Then, in late May, Kodiak Oil & Gas (USA) Inc., a subsidiary of Kodiak Oil & Gas Corp., entered a $200-million, four-year revolving senior secured credit agreement with Wells Fargo Bank. The initial borrowing base was $20 million.

“As a small exploration company, we were always equity-driven,” explains James Henderson, chief financial officer. “But this year, we got to the point where we could look to the debt markets more to finance our future growth, so we established a revolver credit facility with Wells Fargo. The decision to look at debt was largely driven by how our assets were finally to the point of producing cash flows on a reliable basis, and we were establishing dependable, predictable reserves on which to build a borrowing base.

“It was an important switch from an exploration company profile to a true exploration-production company. Once we entered a development mode in our Bakken acreage, this de-risked a lot of it. Now we can book significant reserves and have predictable cash flows.”

Why debt? Henderson says Kodiak’s approach to financing options reflected internal company factors, managing working capital needs and filling gaps in development phases.

“We’re still small enough to have a large capital requirement, and we’re still outspending our cash flows, though we are closing that gap with each new well. Debt became another piece of the pie to help fund that growth. As a small enterprise building cash flows, we had to look at our ability to service the debt rather than all of the facilities that would be available to us.

“A year from now, as we continue along our growth trajectory, we’ll be looking to different types of debt instruments. Most likely we’ll be looking to term up some debt and move it off of the revolver. We still have access to the equity markets, but we want to continue funding a small portion of our growth through debt during the next couple of years as we mature.”

Henderson says the debt markets are open for business but producers still need to have the right assets in their portfolios, with a dependable reserve and production forecast. Exploration is largely an equity-driven exercise with a very conservative use of debt; once companies shift more into production, the debt markets can make more sense.

“Our philosophy has always been very conservative, and part of this perspective is related to the size of our company, and where we are in our maturity cycle. If a company is going to wade into the debt markets, management has to be sure it can service the debt, and weather any volatility in commodity prices.”

Near term, the debt/banking markets are poised to remain a healthy source of capital for the upstream and oil-services sectors, especially when the average cost of equity for either group is about 12%, Petito says.

“When you compare this cost to the after-tax cost of debt, it is easy to see why many companies are sourcing capital in the debt markets. The only proviso is to remember that the capital structure must be balanced against the operating structure of the company, smart hedging must be used to eliminate severe downside, and we must remain realistic with respect to the short- to intermediate-term price environment for natural gas.”

Gregg expects debt to continue to have appeal with upstream companies, though this will be increasingly dependent on M&A activity. Currently, the debt markets continue to draw large capital inflows, especially in high-yield funds, as investors are chasing yield.

“That’s driven a historic level of debt issuance at very attractive levels for companies who have a suitable use of proceeds,” he says.

“There are still substantial amounts of bank and bond maturities coming over the next few years for many companies. If levels stay the way they are, those who can term out or refinance debt as it becomes callable will do so. However, many of the obvious refinancings have been done during the past 18 months, so sustaining the recent high volume of issuance will be more dependent on issuers who have a strategic use of proceeds.”